Structuring Private Funds to Profit from the Oil Price Decline-Due Diligence, Liquidity Management and Investment Options.Indd

The de! nitive source of actionable intelligence on hedge fund law and regulation www.h" awreport.com Volume 8, Number 11 March 19, 2015 ENERGY Structuring Private Funds to Pro! t from the Oil Price Decline: Due Diligence, Liquidity Management and Investment Options By James Deeken, Shubi Arora, Jhett Nelson and Stephen Harrington Akin Gump Strauss Hauer & Feld LLP

Energy companies directly or indirectly reliant on companies have escaped defaulting in bad economic reserve based lending and public equity markets times due to on-hand collateral and the cyclical nature are feeling pressure as markets have tightened, as of their business. However, the rapidity of oil’s price evidenced by recent signi! cant stock declines, IPO decrease, coupled with fears that this price shift signals delays, dividend and distribution cuts and missed a fundamental change in the price of oil, may put many interest payments leading to bankruptcy ! lings. If HY E&P companies into distress due to the borrowing lower prices are sustained, this ! nancial pressure will base constraints and other ! nancial and operational continue over time as reserves are increasingly valued covenants of their credit facilities and indentures as at lower prices, interest rates move upward and poorly well as general declines and tightening of public hedged E&P companies and counterparties face and private capital sources for these companies. unfavorable positions. In such a market, leveraged and shale focused high-yield exploration and production HY E&P companies with large capital expenditure (HY E&P) companies, shale-reliant and undiversi! ed oil needs driven by signi! cant contractual drilling or ! eld services companies and small- to medium-sized production obligations, high utilization of reserve ! nancial institutions with signi! cant exposure to such based credit facilities and reliance on public markets, companies and the boom oil patch areas generally will are especially likely to feel the e$ ects of sustained low oil present distressed investors with plenty of opportunities prices. In recent years, lenders have been readily willing to extract value from current market conditions. Along to provide credit to these companies with a borrowing with the ! nancial considerations, investment funds base tied to higher prices and companies have been looking to take advantage of distressed energy able to supplement their credit facilities by raising opportunities will have to consider various legal additional capital from a market eager to get into matters including structuring the investments, energy. Furthermore, companies found success in due diligence and dealing with convincing lenders to give value to their proved potentially illiquid positions. undeveloped (PUD) reserves in addition to the traditionally considered proved developed producing What Oil Companies Are Facing (PDP) and proved developed non-producing (PDNP) reserves. Thus, with high oil prices and in" ated reserves, During the run-up in oil prices and sustained HY E&P companies were able to fund operations with low interest rate market, many HY E&P companies, leverage and ! nancing that was barely sustainable particularly those exploring higher break-even shale at $80 to $100/bbl, much less at or below $50/bbl. plays, ! nanced their high cost and ambitious drilling programs by taking on signi! cant debt and frequently However, lenders were certainly not going maintain accessing public markets. The continued pro! tability borrowing bases pegged to higher oil prices for long. of these companies will depend on whether or not oil Companies are beginning to see a retrenchment in value prices recover to the higher levels seen over the last given to their reserves as evidenced by the Macquarie year. Many HY E&P companies likely do not have a Tristone Q1 2015 Energy Lender Price Survey, which capital structure that will allow them to withstand reports an approximately 37.7% decrease in West Texas sustained low oil prices. Historically, HY E&P Intermediate (WTI) lender base case front-year pricing since its Q3 2014 survey and this trend appears likely

©2014 The Hedge Fund Law Report. All rights reserved. 1 The de! nitive source of actionable intelligence on hedge fund law and regulation www.h" awreport.com Volume 8, Number 11 March 19, 2015 to continue as front year WTI discount averages are near 100% compared to the 72% to 86% averages seen over In addition to direct plays in HY E&P and oil ! eld services, the past ! ve years. HY E&P companies are beginning ! nancial institutions and funds with signi! cant energy to face scheduled redeterminations of their borrowing exposure in hedging and lending present opportunities bases and as trailing average prices continue to decline, for investment, either directly or by taking over their particularly price sensitive and leveraged companies positions. Many of these institutions, particularly small- (such as those focused on the more expensive shale to mid-size institutions in Texas and other oil-heavy plays) will face increasingly lowered borrowing bases states with a memory of the impact the 1980s oil glut and the greater costs and lesser " exibility that comes and seeing oil prices well below their sensitivity cases, with higher utilization rates. As such, and without the may desire additional capital or to liquidate some of public markets providing ready relief, these companies their riskier hedging and loan positions to lessen their will likely need to consider capital restructuring and overall exposure to the sector. This will likely present seek alternative ! nancing arrangements such as an opportunity to make value investments in otherwise second lien and mezzanine loans and preferred equity. strong ! nancial institutions or to pick up mispriced or A sustained price drop and rising interest rates would discounted hedging and loan positions. likely exacerbate this issue for such companies and cause a number of HY E&P players to fall into the Approaching the Opportunity distressed category and/or to seek consolidation or other M&A maneuvers to monetize assets, diversify or While investors interested in distressed energy lessen exposure to their less pro! table plays. plays have a multitude of options when it comes to structuring transactions, each presents unique risks and With the pressure on E&P companies, low oil prices rewards that must be carefully weighed even though are also putting stress on oil ! eld services ! rms as their speed is a critical factor in maintaining maximum customers scale back and reassess projects in the new leverage in such negotiations. low oil price environment. These delays, and possibly cancellations, of projects will particularly strain smaller Debt in particular is likely to be a preferred structure for oil ! eld services ! rms, who are often not well diversi! ed funds under current market conditions, including taking and are dependent on consistent cash " ow from a positions in current ! rst lien revolvers or senior notes or small roster of key customers, and many will likely infusing new capital through second lien and mezzanine struggle to make up for the revenue gaps and keep ! nancing. Debt provides a " exible investment vehicle for up with increasingly large and diversi! ed competitors an investor looking for exposure to a well-run company (as evidenced by the Halliburton-Baker Hughes and under a liquidity crunch or as a vehicle to eventually take C&J Energy Services-Nabors merger announcements). control of a company if so desired. See “ From Lender to Moreover, massive labor force reductions by key Shareholder: How to Make Your Equity Work Harder for companies in the industry (industry leader Schlumberger You, ” The Hedge Fund Law Report, Vol. 3, No. 20 (May has announced 9,000 layo$ s alone among the more than 21, 2010). In this regard, a debt investment will provide 100,000 in global oil layo$ s reported by Bloomberg) the investor with many options. First, a debt investment indicate that smaller oil ! eld services companies will before bankruptcy will earn the investor a seat at the soon face similarly tough decisions regarding their creditor’s table if a bankruptcy is declared, giving the workforces and ability to operate generally. Thus, in the investor some comfort on receiving a return on the face of these headwinds, many of these companies will investment. Moreover, the investor may have leverage feel signi! cant ! nancial pressure and need to consider in any pre-bankruptcy negotiations with the company alternative ! nancing arrangements or seek their own to gain favorable terms in any future restructuring. consolidation in order to increase e+ ciencies, Further, a signi! cant debt investment can give an market share and pricing power. investor some level of corporate control over the

©2014 The Hedge Fund Law Report. All rights reserved. 2 The de! nitive source of actionable intelligence on hedge fund law and regulation www.h" awreport.com Volume 8, Number 11 March 19, 2015 company if the investor feels that such control is payments from being caught by the automatic necessary to safeguard the investment. Lastly, if the stay (however, investors must be careful because debt investor is interested in taking control of the results can di$ er state by state depending on the form company, such investor may use the bankruptcy of investment as, for example, overriding royalty interests proceedings as a way to trade its debt for equity and VPPs may not have this real property bene! t in, in the plan of reorganization. See “Liquidity for notably, Kansas and Oklahoma). The federal Bankruptcy Post-Reorganization Securities Under Section Code also produces similar results by way of a safe 1145 of the Bankruptcy Code ,” The Hedge Fund harbor which carves out both production payments Law Report, Vol. 3, No. 26 (Jul. 1, 2010). and farmouts from the debtor’s estate. These sorts of direct investments also allow funds to target particular Like debt investments, equity transactions also come assets that may be of interest without the potential drag with their own unique risks and rewards which are often posed by less attractive assets and may come with fewer determined by whether the investment is in a preferred obstacles from existing debt and equity instruments or common position, in the parent company or through and stakeholders as compared to new debt or preferred a joint venture, and whether it is made pre-bankruptcy equity. Moreover, companies may ! nd direct investment or during the bankruptcy proceeding. For example, in advantageous given that it permits monetization of a pre-bankruptcy context, the investor can attempt to assets without dilution of equity or control while utilize its leverage to negotiate favorable terms such as still allowing it to signal to the market that a “new price discounts, higher dividends in a preferred position, partner” has validated the strength of its assets investment in the general partner of a master limited and management team. partnership and in" uence through approval rights and board observation rights or representation. A further Nevertheless, direct investment comes with its own potential bene! t is that there may be fewer hurdles pitfalls. Signi! cantly, a direct investment comes with posed by existing credit and debt instruments to additional risks and concerns that an investor will need issuing equity (but possibly a need to amend to plan for and monitor including direct commodity governance documents) depending on how the price risk, reserve and operational risks, marketing of investment is structured. However, if bankruptcy production received in-kind and, depending on the comes into the picture, a preferred investor would investment structure, potential environmental and ! nd itself ahead of common equity, but any plugging and abandonment liabilities. These sorts of favorable terms negotiated by the investor risks and the peculiarities of the industry may mean the pre-bankruptcy could be wiped out. need to hire or engage oil and gas specialists and to consider extra hedging and insurance actions to better A third general approach to distressed energy protect the investment. Some forms of direct investment investing is through direct investment (particularly may also come with the need to fund additional costs or with respect to E&P properties), including farmout involve actual operating interests, which may not ! t well working interest arrangements, overriding royalty with the funding or structure of the fund. In addition, interests, volumetric production payments (VPPs) and not all of the oil and gas tax deductions apply to all “drill-to-earn” arrangements, amongst others. When forms of direct investment. For example, the deduction properly structured, a direct investment can provide for intangible drilling and development costs and the investors with a key advantage – bankruptcy protection. deduction for depletion are not available if the direct At the state level, such an investment generally takes investment is structured as a VPP. Further, in the context the form of a real property interest which will not be of foreign investors, certain additional U.S. taxes related considered part of the debtor’s estate in bankruptcy to the Foreign Investment in Real Property Tax Act and will also help protect the related production (FIRPTA) may apply and would need to be monitored.

Speed vs. Diligence considerations in distressed investing. With borrowing base redeterminations and capital expenditure shortfalls While speed is a key factor in distressed investment looming and no signi! cant increase in the price of in order to maintain maximum leverage, investors oil predicted, viable energy company targets will be should at least be sure to undertake a careful baseline foremost on distressed investor’s minds. Therefore, due diligence process to identify key issues facing creating a sophisticated, tailor-made fund should be a the investment. This will help funds see roadblocks key consideration for any fund manager looking to take that may stand in the way of the preferred investment advantage of the opportunities outlined above. Tax strategy and avoid future issues and reduced returns that considerations also need to be on managers’ minds, may arise from structural problems and undiscovered especially those looking at master limited partnerships liabilities. Such a process would include a detailed or direct investments, which can create operating, review of existing capital arrangements, such as credit reporting and pass-through issues for the fund and agreements, indentures and preferred shares, along with both foreign and domestic investors. See “ Tax and diligence on the existing creditors and shareholders to Structuring Considerations for Funds Organized to determine the existing stakeholders’ level of resistance Invest in Master Limited Partnerships ,” The Hedge to (or interest in joining) a new investment. Failure to Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013). do so may result in a fund expending e$ orts towards a type of investment that is not workable under existing Lastly, fund managers need to consider how to handle arrangements, being mired in long and arduous potentially illiquid positions that may come from negotiations with existing stakeholders or could even investing in distressed companies, which implicates lead the company into default, thereby giving existing issues often seen with hybrid funds. Oftentimes during stakeholders even more in" uence over the company bankruptcy, the securities of the bankrupt company will at the expense of the new investor. become illiquid due to the automatic stay and fraudulent transfer concerns, amongst others. The complexity of Whether debt, equity or direct, a baseline level of dealing with illiquid investments can create issues at diligence is paramount in evaluating any investment; the fund level as investor funds move in and out. Thus, however the need for speed in these sorts of investments utilizing side pockets for distressed energy investments means that a more fulsome diligence process cannot can be helpful to ensure that investor redemption always be undertaken. One option funds can consider requests do not cause stress during the bankruptcy to mitigate the downside risk in such a situation would proceeding or the fund manager’s investment be by securing representation and warranty insurance. strategies. On hybrid funds, side pockets and By focusing on key due diligence matters, investors can redemption management mechanisms generally, ensure that any major issues are discovered through see “Structures and Characteristics of Activist their internal due diligence processes and the risk of Alternative Investment Funds ,” The Hedge Fund more remote liabilities can be passed on to a third Law Report, Vol. 8, No. 10 (Mar. 12, 2015). party by obtaining such insurance. In addition, even when a fund is focused on a liquid Fund Structuring Considerations investment strategy in the energy industry, such as investing in publicly-traded debt of distressed energy

In addition to transaction level considerations, companies, it may take a fund manager time to identify investment funds should keep several things in investment opportunities in the space. Thus, a manager mind when structuring funds for distressed energy may wish to consider a fund with a short draw-down investments – e+ ciency of fund formation, tax period rather than requiring the investors to contribute considerations and handling illiquid investments. all capital up front, as is typically the case with funds that As discussed above, speed is one of the most important pursue a liquid investment strategy.

James Deeken is a partner in Akin Gump’s investment funds and private equity practice. He focuses primarily on matters related to the representation of private fund managers in fund formation activities and in the representation of investment funds engaged in business transactions.

Shubi Arora is a partner in Akin Gump’s oil & gas and natural resources practice, focusing on mergers, acquisitions and divestitures; private equity investments; and joint ventures and similar strategic transactions.

Jhett Nelson is a counsel in Akin Gump’s oil & gas and natural resources practice, with a focus on mergers, acquisitions and divestitures; public and private capital markets and investment transactions; ! nance and derivatives; and other general corporate, commercial, governance and securities matters for a variety of companies and investment funds.

Stephen Harrington is an associate in Akin Gump’s oil & gas and natural resources practice, focusing on corporate and securities matters.